Monday, July 11, 2011

Long-term or short-term? MU!

Paul Krugman says that there's not much that government policy can do to promote long-term growth:

Changing the economy’s long-run growth rate is hard. We’ve had almost 25 years of “new growth theory” research, with every possible regression run, looking for the keys to faster growth; my sense is that we’ve basically come up dry.

[We] heard the President during the townhall talk about life long education, infrastructure, etc.

Yet, either the government has been amazingly consistent in providing the right balance of these goods, or they just don’t matter that much. Because long term growth has been incredibly consistent, even including the Great Depression and WWII.

Now I am all for stabilization policy (as long as it comes in the form of infrastructure spending and QE instead of tax rebates). But I also tend to think that the long term matters a lot. And in America's current situation, I don't think there's that much of a tradeoff between the two!

Smith's point is, I think, fairly well rebutted by Brad DeLong, who notes that not every country seems as resilient to economic shocks as the U.S. It might be that our government was just amazingly consistent in the 20th century. And as both DeLong and I have noted, past performance is no guarantee of future results. (Update: M.S. at The Economist also offers a rebuttal to K. Smith.)

Regarding Krugman's argument…Well, just because "New Growth Theory" hasn't found any definitive answers doesn't mean that there aren't any. After all, growth theory is working with terrible data. Countries are not selections from a random sample, and the time series of post-WW2 growth is not very long.

What about the development literature? I think it provides more of a reason to believe that policy could matter for the long-term. When we look at a poor as well as rich countries, we see a large and persistent variance in levels of income. Convergence is only conditional on institutions and other country-specific variables.

Now, I acknowledge that it seems unlikely that the U.S. will make policy mistakes significant enough to tumble us out of the ranks of the rich countries. But there's no rule that the principles of development economics don’t apply to us! In particular, much of the development literature emphasizes the importance of institutions for living standards; there seems to me no reason to assume that once a country reaches the highest levels of per-capita income, its institutions are forever guaranteed to be top-notch.

This is my big worry about the current crisis. When I think of what might hold down our long-term growth, I think about political-economic equilibria and the quality of our institutions. What if an economic shock is severe enough to knock a country out of a good (but fragile) political-economic equilibrium - where factions basically agree on the need for public good provision and sound macro policy - and into a bad one, where no one can agree on anything?

Casual observation says that this may be what happened to Japan. A prolonged slump (compounded by macro policy mistakes) was followed by decades of political chaos that have seen prime ministers come and go like fashion trends. Gridlock has led to too-low taxes and massive debt, while trade and immigration policies remain stuck in the past. Now, personally, I think Japan's political institutions were never particularly good, but I also think that what virtue they had proved to be fragile to external events.

Looking at our current crisis over the debt ceiling, I can't help but worry that something similar is happening to us. Our nation needs to raise taxes, but we can't. Our infrastructure is falling apart, but we can't fix it. We seem to have reached a political-economic equilibrium in which the Republican Party, either by filibusters or by cyclical election victories, will always have the clout to throttle spending on public goods and prevent the taxes and health-care reform that are needed to close our own unsustainable deficits – and because Republicans are ruled by primary elections in the South and by Grover Norquist, their incentives will not soon align with the nation’s. As our roads and our health care system deteriorate, I am comforted neither by a long-term log-log plot of U.S. GDP nor by the limited usefulness of New Growth Theory.

Mark Thoma argues that long-term-ism is a basically conservative policy stance, since the RBC people and the "structural unemployment" people urge us to ignore stabilization policy and focus on things like lowering taxes. I don't think that's necessarily true, for two reasons. First, just because the long-term is important does not mean that conservative policy ideas are right. Conservatives' main mistake is to ignore market failures; yes, this leads them to ignore stabilization policy, but it also makes them ignore public goods. Second, just because the short-term is important does not mean that the long-term is not. The same political-economic dysfunction that stops us from implementing timely and appropriate stabilization policy also stops us from rebuilding our roads.

All that being said, here's the upshot of my post: I certainly am NOT saying we should ignore stabilization policy. If short-term policy and long-term policy were really in conflict right now, I would say we should carefully balance the two. But I don't think they are in conflict! We shouldn’t be afraid that raising taxes will harm the macro situation, because (as John Taylor and Paul Krugman both point out) tax cuts make poor stimulus. And spending more on infrastructure would be good for both short-term employment and long-term efficiency. So I really think there is no tradeoff right now.

And I think that with the kind of dysfunctional political economy we’ve got, both long-term rhetoric (of the type Obama is using) and short-term rhetoric are needed to bring people back to their senses.